Monetary Authorities Staying One Step Behind

Bill Ehrman

20 Mar 2017

The BOJ, ECB and the Fed have now spoken, maintaining overly easy monetary policies permitting the global economies to continue to pick up momentum. The reflation trend is alive and well even before any of President Trump’s agenda, “Making America Great Again” and “America First”, is passed into law, which will further stimulate domestic and even foreign growth rates.

The key event of the week was the Fed meeting along with Janet Yellen’s followup press conference. The Fed raised rates by a quarter of a point as expected; confirmed that growth was improving but did not change their forward forecasts of future rate hikes which includes only two more this year. More importantly Janet Yellen confirmed that the Fed would wait to see the impact of Trump’s agenda once passed before changing their forecasts. The Fed continued to forecast economic growth and inflation averaging 2% over the next three with the Fed funds rate reaching only 3% by the end of 2019. I could live with that, as the real rate would be most likely less than 1% at that point, which certainly would not stop the economy from continuing to expand into 2020. Corporate profits would even increase by over 8% per annum under this scenario with S & P earnings exceeding $155 per share by 2020 even without a tax cut, a trillion dollar infrastructure program and fairer trade deals.

However, I still anticipate tax reform and a major infrastructure program to pass sometime this fall with the benefits accruing to our economy beginning next year well into 2019 and 2020. Also I expect the trade balance will improve over time boosting GNP growth also basically for two reasons: 1) domestic and foreign corporations will be adding capacity domestically to fill U.S. demand while cutting back on imports from plants abroad; and 2) growth in domestic oil production should cut the amount of imported oil from abroad. Notwithstanding this obvious outlook for the next few years, the Fed will continue on a very moderate path of raising rates until after passage and seeing the benefits to growth from the Trump agenda; therefore remaining one step behind while the financial markets will continue to anticipate the benefits of these programs well in advance of their passage.

Stock markets got an all-clear signal from the Fed on Wednesday such that the reflation beneficiaries led the market gains for the week. Interestingly, the financial stocks paused after the Fed raised rates as the longer end of the bond market rallied as large foreign capital inflows helped flatten the yield curve as the short end rates rose. Interestingly the dollar lost ground as investors sensed the Fed staying one step behind remaining overly accommodative.

Economic data from the United States to Europe to India to China and to Japan supported acceleration in global growth, supporting our reflation thesis. Industrial commodity and energy prices rose after the Fed decision too. While I was pleasantly surprised by the vote in Holland, I was disappointed that the meeting between President Trump and German Chancellor Merkel did not go well. I also felt that the G-20 meeting was not successful as U.S. Treasury Secretary Steve Mnuchin promoted “America First” rather than a communiqué against protectionism. Clearly he was making a statement to members of the G-20 to support fair trade or else. Let’s hope that this was just a bargaining ploy to get some movement on renegotiation of trade deals. I think so. By the way, I agree that all NATO members should pay their agreed-upon share of the alliance.

The bottom line is that the reflation thesis is alive and well. You need to be patient, as it may take more time than many anticipate passing the Trump agenda. But I am confident that a Republican President and Congress will get it all done, including passage of the American Healthcare Act, with some minor tweaks along the way. The stock market winners will include those industries and companies that will benefit most from the Trump agenda including industrials, capital goods, financial, technology, transportation, and industrial commodity companies where earnings growth will far outstrip the decline in market multiple as interest rates continue to rise. The losers/underperformers will include bonds and companies with moderate earnings growth less than the decrease in the market multiple as rates rise which includes consumer nondurables and durables, old pharma, utilities, REITs, and box store retailers. Active management will outperform passive management in a rotational market.